Mitigating Turkey's trilemma trade-offs

Abstract

We study the trilemma conguration of the Turkish economy for the period between 2002 and 2012. The paper starts by empirically testing the Mundell-Fleming theoretical concept of an \impossible trinity" (trilemma) for Turkey, following Aizenman, Chinn and Ito (ACI, 2008). This includes calculating the trilemma indices and regressing them on a constant. We show that there is a misspecication with ACI approach and improve the specication by applying a Kalman lter to the classical linear regression that enables us to capture the time-varying importance of policy decisions within the trilemma framework. By comparing the residuals of each approach, we show that Kalman lter analysis has superior results. Then, our analysis continues by revealing a role for central bank foreign reserves and required
reserves in mitigating the trilemma tradeos { we show that foreign reserves to GDP ratio and required reserve ratio have positive signicant impact on the residuals obtained from the trilemma regression, thus making the policy
tradeos smaller.